Recap From September’s Picks
On a price return basis, the Dividend Growth Stocks Model Portfolio (+5.5%) underperformed the S&P 500 (+6.1%) by 0.6%, and on a total return basis, the Model Portfolio (+5.6%) underperformed the S&P 500 (+6.1%) by 0.5%. The best performing stock outperformed the S&P 500 by 18%. Overall, 13 out of the 30 Dividend Growth Stocks outperformed the S&P 500 from September 29, 2022 through October 25, 2022.
The methodology for this model portfolio mimics an “All Cap Blend” style with a focus on dividend growth. Selected stocks earn an attractive or very attractive rating, generate positive free cash flow (FCF) and economic earnings, offer a current dividend yield >1%, and have a 5+ year track record of consecutive dividend growth. This model portfolio is designed for investors who are more focused on long-term capital appreciation than current income, but still appreciate the power of dividends, especially growing dividends.
Featured Stock From October: Snap-On Inc.
Snap-On Inc. (SNA) is the featured stock from October’s Dividend Growth Stocks Model Portfolio. I made SNA a Long Idea in February 2018. Since then, the stock is up 39% vs. a 37% gain for the S&P 500.
Snap-On has grown revenue by 5% compounded annually and net operating profit after-tax (NOPAT) by 10% compounded annually since 2011. The company’s NOPAT margin rose from 12% in 2011 to 19% over the trailing twelve months (TTM), while return on invested capital (ROIC) rose from 11% in 2011 to 16% over the same time.
Figure 1: Snap-On’s Revenue and NOPAT Since 2011
FCF Exceeds Dividends by a Wide Margin
Snap-On has increased its dividend in each of the past 12 years. The company increased its regular dividend from $2.95/share in 2017 to $5.11/share in 2021, or 15% compounded annually. The current quarterly dividend, when annualized, equals $5.68/share, and provides a 2.6% dividend yield. Snap-On last increased its dividend on November 4, 2021. Should the company increase its dividend for a 13th consecutive year, the dividend yield would be even higher at the current stock price.
More importantly, Snap-On’s strong free cash flow (FCF) easily exceeds the company’s growing dividend payments. From 2017 – 2021, Snap-On’s cumulative $2.9 billion (24% of enterprise value) in FCF is 2.6x the $1.1 billion paid out in dividends, per Figure 2. Over the TTM, the company generated $539 million in FCF and paid out $303 million in dividends.
Figure 2 also shows that Snap-On’s FCF significantly exceeded its dividend payments in each of the past five years.
Figure 2: Free Cash Flow vs. Regular Dividend Payments
Companies with FCF well above dividend payments provide higher quality dividend growth opportunities because I know the company generates the cash to support a higher dividend. On the other hand, dividends that exceed FCF cannot be trusted to grow or even be maintained, due to insufficient cash flow.
Snap-On Has Upside Potential
At its current price of $221/share, SNA has a price-to-economic book value (PEBV) ratio of 0.9. This ratio means the market expects Snap-On’s NOPAT to permanently decline by 10%. This expectation seems overly pessimistic for a company that has grown NOPAT by 10% compounded annually since 2011 and 14% compounded annually since 2001.
Even if Snap-On’s NOPAT margin falls to 18% (five-year average) and the company grows revenue by just 4% compounded annually for the next 10 years, the stock would be worth $280+/share today – a 27% upside. In this scenario, Snap-On’s NOPAT would grow just 3% compounded annually over the next decade. See the math behind the reverse DCF scenario.
Should the company grow NOPAT more in line with historical growth rates, the stock has even more upside. Add in Snap-On’s 2.6% dividend yield and a history of dividend growth, and it’s clear why this stock is in October’s Dividend Growth Stocks Model Portfolio.
Critical Details Found in Financial Filings by My Firm’s Robo-Analyst Technology
Below are specifics on the adjustments I make based on Robo-Analyst findings in Snap-On’s 10-Ks and 10-Qs:
Income Statement: I made $111 million in adjustments with a net effect of removing $55 million in non-operating expenses (1% of revenue).
Balance Sheet: I made $1.4 billion in adjustments to calculate invested capital with a net decrease of $233 million. The most notable adjustment was $344 million (6% of reported net assets) in other comprehensive income.
Valuation: I made $1.9 billion in adjustments, with a net decrease to shareholder value of $547 million. Apart from total debt, the most notable adjustment to shareholder value was $663 million in excess cash. This adjustment represents 6% of Snap-On’s market value.
Disclosure: David Trainer, Kyle Guske II, Matt Shuler, and Italo Mendonça receive no compensation to write about any specific stock, style, or theme.